Insider Trading with Uncertain Informed Trading

This paper develops a model of securities market with a strategic trader whois potentially better informed than the public. Unlike in the Kyle model (Kyle(1985) and Back (1992)), market makers do not have perfect information aboutwhether the strategic trader is informed. With common prior beliefs, not onlydo market makers need to update their value estimate as in the Kyle model,but they also have to update their estimate of the probability that the strategictrader has private information based on the observed cumulative order flow.The dynamics of this probability estimate causes the resulting equilibrium pricingrule to be nonlinear and yield richer price dynamics than that in the Kylemodel. Some properties of market depth and price volatility are discussed indetail through the examples with lognormal and normal distributions.Keywords: Asymmetric Information, Informed Trader, Price Impact, Probabilityof Informed Trading, Volatility